Money and Monetary Policy. Meaning and Functions of Money The functions of money –medium of exchange –means of storing wealth –means of evaluation –means.

Money and Monetary

Policy

Money and Monetary

Policy

Meaning and Functions of MoneyMeaning and Functions of Money

• The functions of money

– medium of exchange

– means of storing wealth

– means of evaluation

– means of establishing value of future claims and payments

• What should count as money?

– narrow definitions of money

– broad definitions of money

Financial System in the UKFinancial System in the UK

• The key role of banks

– deposits and loans

– liabilities and assets

– retail and wholesale deposits and loans

• Liabilities

– sight deposits

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• The key role of banks– deposits and loans

– liabilities and assets

– retail and wholesale deposits and loans

• Liabilities– sight deposits

– time deposits

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• The key role of banks– deposits and loans

– liabilities and assets

– retail and wholesale deposits and loans

• Liabilities– sight deposits

– time deposits

– certificates of deposit

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• The key role of banks– deposits and loans

– liabilities and assets

– retail and wholesale deposits and loans

• Liabilities– sight deposits

– time deposits

– certificates of deposit

– repos

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• Assets

– cash and balances with the Bank of England

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• Assets

– cash and balances with the Bank of England

– short-term loans

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• Assets

– cash and balances with the Bank of England

– short-term loans

– longer-term loans

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• Liquidity and profitability

– profitability

– liquidity

• the liquidity ratio

Balance sheet of UK banks: February 2003Balance sheet of UK banks: February 2003

Financial System in the UKFinancial System in the UK

• The central bank– Bank of England, ECB, Fed, etc.

– functions• note issue

• acts as a bank– to the government

– to overseas central banks

• overseas activities of banks

• provides liquidity to the banks– lender of last resort

• operates monetary and exchange rate policy

Financial System in the UKFinancial System in the UK

• The London money market

– the discount and repo markets• discounting

• the repo market

• last-resort facilities by Bank of England

– the parallel money markets• the inter-bank market

• inter-companies deposit market

• market for certificates of deposit, etc.

• foreign currencies market

The Supply of MoneyThe Supply of Money

• Definitions of the money supply

– monetary base

– broad money

• Definitions in the UK

– definitions in the UK: M0, M4

UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)

Cash outside Bank of England

+ Banks’ operational deposits with Bank of England

= M0

Cash outside banks (in circulation)

+ Private-sector retail bank and building society deposits

= Retail deposits and cash in M4 (also known as M2)

+ Private-sector wholesale bank and b.s. deposits + CDs

= M4

36 861

91

36 952

30 630

676 969

707 599

295 996

1 003 595

£ million

UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)

Cash outside Bank of England

+ Banks’ operational deposits with Bank of England

= M0

Cash outside banks (in circulation)

+ Private-sector retail bank and building society deposits

= Retail deposits and cash in M4 (also known as M2)

+ Private-sector wholesale bank and b.s. deposits + CDs

= M4

36 861

91

36 952

30 630

676 969

707 599

295 996

1 003 595

£ million

UK monetary aggregates: (end February 2003)UK monetary aggregates: (end February 2003)

Cash outside Bank of England

+ Banks’ operational deposits with Bank of England

= M0

Cash outside banks (in circulation)

+ Private-sector retail bank and building society deposits

= Retail deposits and cash in M4 (also known as M2)

+ Private-sector wholesale bank and b.s. deposits + CDs

= M4

36 861

91

36 952

30 630

676 969

707 599

295 996

1 003 595

£ million

The Supply of MoneyThe Supply of Money

• Definitions of the money supply

– monetary base

– broad money

• Definitions in the UK

– definitions in the UK: M0, M4

– euro zone definitions: M1, M2, M3

UK monetary supply using ECB measures:(end February 2003)

UK monetary supply using ECB measures:(end February 2003)

Currency in circulation

+ Overnight deposits

= M1

+ Deposits with agreed maturity up to 2 years

+ Deposits redeemable up to 3 months' notice

= M2

+ Repos

+ Money market funds and paper

= M3

31 351

513 292

544 643

81 696

296 518

922 857

88 978

57 496

1 069 331

£ million

UK monetary supply using ECB measures:(end February 2003)

UK monetary supply using ECB measures:(end February 2003)

Currency in circulation

+ Overnight deposits

= M1

+ Deposits with agreed maturity up to 2 years

+ Deposits redeemable up to 3 months' notice

= M2

+ Repos

+ Money market funds and paper

= M3

31 351

513 292

544 643

81 696

296 518

922 857

88 978

57 496

1 069 331

£ million

UK monetary supply using ECB measures:(end February 2003)

UK monetary supply using ECB measures:(end February 2003)

Currency in circulation

+ Overnight deposits

= M1

+ Deposits with agreed maturity up to 2 years

+ Deposits redeemable up to 3 months' notice

= M2

+ Repos

+ Money market funds and paper

= M3

31 351

513 292

544 643

81 696

296 518

922 857

88 978

57 496

1 069 331

£ million

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit– simple illustration

Credit creation: Banks' original balance sheetCredit creation: Banks' original balance sheet

Credit creation: Effect of a new deposit of £10bn Credit creation: Effect of a new deposit of £10bn

Credit creation: Full effect of a new deposit of £10bn Credit creation: Full effect of a new deposit of £10bn

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit– simple illustration

– the bank multiplier

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit– simple illustration

– the bank multiplier• 1/L

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit– simple illustration

– the bank multiplier• 1/L

– the real world

The Supply of MoneyThe Supply of Money

• Definitions of the money supply– monetary base

– broad money

• Definitions in the UK

• The creation of credit– simple illustration

– the bank multiplier• 1/L

– the real world• no precise bank multiplier

The Supply of MoneyThe Supply of Money

• Causes of increases in money supply

– banks reduce liquidity ratio

– inflow of funds from abroad

– PSNCR and its financing

• Money supply: exogenous or endogenous?

– Relationship between money supply and the rate of interest

The supply of money curve: (a) exogenous money supplyThe supply of money curve: (a) exogenous money supply

O

Ra

te o

f in

tere

st

Quantity of money

MS

The supply of money curve: (b) endogenous money supplyThe supply of money curve: (b) endogenous money supply

O

Ra

te o

f in

tere

st

Quantity of money

MS

The Demand for MoneyThe Demand for Money

• The motives for holding money– transactions and precautionary motive– assets or speculative motive– the total demand for money

• Determinants of demand for money– money national income– frequency with which people are paid– financial innovations– speculation about future return on assets– rate of interest

The demand for money (liquidity preference) curveThe demand for money (liquidity preference) curve

O

Ra

te o

f in

tere

st

Md

Money

Monetary EquilibriumMonetary Equilibrium

• Equilibrium in the money market– equilibrium interest rate where D and S

of money are equal

Equilibrium in the money marketEquilibrium in the money market

O

Ra

te o

f in

tere

st

Md

Money

MS

re

Me

Monetary EquilibriumMonetary Equilibrium

• Equilibrium in the money market

– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market

Monetary EquilibriumMonetary Equilibrium

• Equilibrium in the money market

– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market

– increased money supply leads to lower interest rates

Monetary EquilibriumMonetary Equilibrium

• Equilibrium in the money market

– equilibrium interest rate where D and S of money are equal

• Equilibrium in the foreign exchange market

– increased money supply leads to lower interest rates

– lower interest rates lead to a lower exchange rate

Monetary EquilibriumMonetary Equilibrium

• Effects of changes in money supply on national income– effect on interest rates

• Ms r

The demand for and supply of moneyThe demand for and supply of money

O

Money

Ra

te o

f in

tere

st

MS

Md

r1

Q1

O

Money

Ra

te o

f in

tere

st

Md

r1

Q1

r2

Q2

MS' MS

The demand for and supply of moneyThe demand for and supply of money

Monetary EquilibriumMonetary Equilibrium

• Effects of changes in money supply on national income– effect on interest rates

• Ms r– effects of changes in interest rates on

investment• r I

Monetary EquilibriumMonetary Equilibrium

• Effects of changes in money supply on national income– effect on interest rates

• Ms r– effects of changes in interest rates on

investment• r I

– effects of changes in interest rates on the exchange rate, and imports and exports

• r er X, M

Monetary EquilibriumMonetary Equilibrium

• Effects of changes in money supply on national income– effect on interest rates

• Ms r– effects of changes in interest rates on

investment• r I

– effects of changes in interest rates on the exchange rate, and imports and exports

• r er X, M– effects of changes in investment, imports

and exports on national income• I, X, M Y

Monetary PolicyMonetary Policy

• The significance of monetary policy

• The policy setting

– relationship between the government and the central bank

– degree of central bank independence

• Medium- and long-term policy

– control of banks’ liquidity ratio

– restricting size of PSNCR

Monetary PolicyMonetary Policy

• Short-term monetary control– techniques to control money supply

• open-market operations

• reduced central bank lending to the banks

• funding

• variable minimum reserve ratios

– techniques to control interest rates• announcing changes in interest rates

• backing up announcements– operations in the discount and repo markets

– credit rationing

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Medium and long-term control over the money supply: reducing PSNCR– automatic fiscal stabilisers– the desire to cut taxes– difficulty in cutting government

expenditure

• Short-term control of the money supply– use of money supply targets– ways in which banks resist attempts to

restrict the growth in the money supply– demand-determined money supply

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

O

Demand for loans

Q1Q2

Assume that the authoritieswant to reduce the

demand for money to Q2

r1

Loans

Rat

e of

inte

rest

An inelastic demand for loansAn inelastic demand for loans

r2

O

Demand for loans

r1

Q1Q2

A large rise in therate of interest (to r2)

will be necessary

Loans

Rat

e of

inte

rest

An inelastic demand for loansAn inelastic demand for loans

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money• problem of changing expectations

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money• problem of changing expectations• speculation

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money• problem of changing expectations• speculation

– possible conflict between domestic goals and exchange-rate goals

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money• problem of changing expectations• speculation

– possible conflict between domestic goals and exchange-rate goals

• Using monetary policy

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy

• Effectiveness of controlling interest rates– inelastic demand for loans

• problem of possibly high interest rates• reasons for an inelastic demand for loans

– unstable demand for money• problem of changing expectations• speculation

– possible conflict between domestic goals and exchange-rate goals

• Using monetary policy– use of interest rates to meet inflation

target

Effectiveness of Monetary PolicyEffectiveness of Monetary Policy